TURMOIL IN BRAZIL: THE ECONOMICS -- One Choice Made, More to Come; Why Brazil Did What It Did and What Options Are Left

By SYLVIA NASAR

Published: January 16, 1999

On Wednesday, Brazil drew a line in the sand in front of its embattled currency, the real. Yesterday, it erased that line, sending the sand scattering, as it allowed the real to trade freely against other currencies.

That abrupt reversal came after investors doubted the Brazilian Government's ability to defend the currency following the resignation of Brazil's hard-money central bank chief, Gustavo Franco, and the 9 percent devaluation in the real's value on Wednesday.

After yesterday's surprise move, the real tumbled another 8 percent, but stock markets from Toronto to Santiago surged in apparent relief that Brazil would no longer waste billions of dollars propping up the currency. For a day, at least, Brazil did not threaten to spin out of control, taking the rest of Latin America down with it.

But throwing in the towel on its old policy of pegging the real to the dollar is only a stopgap. Now the Brazilian Government and international finance policy makers must wrestle with what comes next.

Brazil has the same choices that other countries with tottering currencies have had. It can continue allowing the currency to trade freely, or it can try to set a new trading range and maintain that range by buying reais in the foreign exchange market.

Or it can follow the more radical example of its neighbor Argentina, and set up a currency board, which would peg the real to the dollar at a fixed rate of exchange.

Such options are likely to be discussed this weekend, when Brazil's Finance Minister and central bank chief meet in Washington with officials from the International Monetary Fund and the United States Treasury Department.

Whatever Brazil's decision, it will reverberate throughout the world. The impact will be felt most heavily in Argentina, Brazil's biggest trading partner and, like Brazil, a country that has only recently recovered from years of hyperinflation. Should the Brazilian currency be allowed to trade freely, it is unclear how the Argentine peso could keep its dollar peg when most of its exports and imports will be priced in a currency that can fluctuate wildly in value. Currency volatility is the last thing Latin American economies need, as they enter a period of slowing growth and rising unemployment.

For American investors and businesses, the Brazilian eruption is the latest chapter in a contagious currency crisis that started in Thailand in July 1997 and spread as far as Russia last summer. If the turmoil leads to a prolonged downturn on Wall Street or cuts heavily into American exports, the robust economy in the United States could turn anemic. Here is a brief guide to what is at stake and what might happen next:

Q. Why is Brazil so important?

A. Brazil is the biggest economy in Latin America, about twice as big as Mexico's. While it buys just 3 percent of United States exports, its economic health is vital to a region that accounts for one-fifth of United States exports. But Brazil looms even larger in the minds of international investors for the simple reason that it was one of the last large countries to go down the road of free trade, privatization and hard money. If that approach fails in Brazil, the ideal of a unified global economy knit together by trade and investment is threatened. That is one reason that the I.M.F. cobbled together one of the biggest rescue packages in history, and one factor in the Federal Reserve's decision to lower interest rates in the United States three times last fall.

Q. What's a devaluation?

A. Both devaluation and depreciation refer to a decline in the value of a currency. The distinction is this: when a government has declared that it is pegging its currency to another and will defend it by any means necessary but lets it fall anyway, that is a devaluation; when the falling currency is that of a country that allows the market to set its value and its value falls, that is a depreciation. One involves a broken promise; the other doesn't.

When Brazil announced its devaluation, overseas investors saw it as a sign that the Government was caving in to political pressure from unions and big business to put its anti-inflation strategy on the back burner and to fight unemployment instead.

Q. Why did Brazilians make the choices they made?

A. Brazil pegged its currency to the dollar in the first place as a way of convincing investors at home and abroad that it would no longer tolerate the chronic inflation that has plagued it for decades. When the so-called Real Plan was enacted in 1994 inflation was running at more than 3,000 percent. Like Russia and scores of other developing countries, Brazil had long financed huge Government commitments mainly by printing money rather than collecting taxes.

But fixing the exchange rate and getting inflation down initially proved easier than scaling back Government commitments. Brazil has a social security system that allows workers to retire after 20 years, often with pensions higher than the pay workers were earning on the job. What is more, it takes the equivalent of a constitutional amendment to lay off public workers.